Financial leverage ratio helps in determining the effect of debt on the overall profitability of the company – high financial leverage means the fixed cost of running the business are high, whereas, lower financial leverage implies lower fixed cost investment in the business.

What is Financial Leverage?

Financial leverage indicates how much a business is dependent on the debt that it has issued. Financial Leverage primarily tells us how the company is using debt as a part of its financing strategy and its dependency on borrowings.

Pepsi’s Financial Leverage was around 0.50x in 2009-2010, however, Pepsi’s leverage has increased over the years and is currently at 3.38x.

What does this mean for Pepsi? How did its Debt to Equity Ratio increase dramatically? Is this good or bad for Pepsi?

Financial leverage Video

Financial Leverage Definition

The term leverage, in the field of business, refers to the use of different financial instruments or borrowed capital in order to increase the firm’s potential ROI or return on investment.

When given a generalized and more technical definition, financial leverage is the extent up to which a firm utilizes the available financial securities, such as equity and debt. It indicates the extent of reliance of a firm’s business over the available debt in the firm’s business operations.

The formula of financial leverage with regards to a company’s capital structure can be written as follows:

Financial leverage Formula = Total Debt / Shareholder’s Equity

Please note that Total Debt = Short Term Debt + Long Term Debt.

The higher the value of leverage, the more that particular firm uses its issued debt. A large value for leverage means a much higher interest rate, resulting in higher interest expenses. And this can negatively affect the firm’s bottom line and earnings per share.

But at the same time, the leverage value should not go down too low, as the firms issuing too much equity is considered less secure because the amount of risk in equity markets is too high.

So in a way, leverage is also an effective way to understand and analyze financial risks faced by an organization in its business. Financial risk is a single word used as a general term for several kinds of risks associated with the finances of a business.

These risks include all the risks involving monetary transactions, such as company loans, and its exposure to loan default. The term is often used to reflect an investor’s uncertainty regarding the collection of returns and also the potential of a financial loss.

Leverage of Oil and Gas Sector, in general, has increased. It all started primarily since 2013-2014 when the slowdown in commodity began, which not only resulted in reduced cash flows but also led these companies to borrow thereby straining their balance sheet.

Did Marriott Raise Large Amounts of Debt?

Marriott Current Portion of Long Term Debt increased marginally to $309 million in 2016 as compared to $300 million in 2015. However, its long term debt debt increased 115% in 2016 to $8,197 million. This is one of the primary reasons for a big jump in leverage.

Investigating Shareholder’s Equity

Did Shareholder Equity decrease? No It didn’t.

Do have a look at snapshot below of Shareholder’s Equity of Marriott Internation.

We note that Shareholder’s Equity of Marriott International has increased from a -$3,590 million in 2015 to $5357 million in 2016. The increase was primarily due to Marriott common stock and equity-based awards issued in the Starwood Combination.

Therefore we can conclude that the increase in Leverage ratio of Marriott was a result of Higher Debt.

What is Degree of Financial Leverage

The Degree of Financial Leverage, or in short DFL, is a financial leverage ratio calculated with a different formula from the one that is commonly used for the calculation of leverage value of an organization.

DFL is a ratio that measures the sensitivity of a company’s earnings per share (EPS) to the fluctuations in its operating financial gain, because of the changes in its capital structure. DFL measures the percentage of change in EPS for a unit change in earnings before interest and taxes (EBIT).

The ratio shows that the more the value of the degree of financial leverage, the more volatile is the EPS. Since interest is a fixed expense, leverage magnifies returns and EPS, which is good in situations where the operating income is rising. However, it is unfavorable in bad economic times when the operating income is declining.

Accenture – DFL Example

Let us look at Accenture example to get an understanding of the calculation of the Degree of Financial Leverage. Below is the Income Statement of Accenture pulled from its SEC Filings.

DEGREE of FINANCIAL LEVERAGE OF ACCENTURE – 2015

We note that Accenture’s Leverage Ratio in 2015 was 1.57x, however, it increased to 4.12x in 2016. Why?

There is something not right about our calculation of leverage ratio of 2016. If you look closely at the Accenture’s 2016 Income Statement, we note that there is Gain on Sale of Business of $848,823 added after Operating Income (EBIT). This gain doesn’t occur in the previous years.

If we want to make an apple to apple comparison, we should have deducted this gain on Sale of Business and normalized the EPS. This normalized EPS should’ve been used for the Leverage Ratio calculations.

Please note that Degree of Financial leverage is thus extremely valuable for helping an organization assess the quantity of debt or leverage it ought to choose in its capital structure. If operating financial gain is comparatively stable, then earnings and EPS (Earnings Per Share) would be stable as well, and the company will be able to afford taking a large amount of debt. However, if the firm operates in a sector where operating financial gain is kind of volatile, it may be prudent to limit the debt to easily manageable levels.

Degree of Financial Leverage – Utilities Sector

Below table provides us with the list of top Utilities companies along with their Market Cap, Leverage, EBIT and EPS Growth and Degree of Financial leverage.

Conclusion

As we have seen from the article financial, leverage is a two edged sword, which on one hand, magnifies the profit of the firm while on the other hand, can also increase the potential for loss. Therefore, the type of industry and the state of the economy, in which a company operates, are two very important factors to be considered before concluding the most appropriate amount of leverage.

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This has been a guide to what is Financial Leverage, formula, and its calculation. Here we also take the degree of financial leverage examples of companies like Accenture, Nestle, Marriot and also sectors including Technology, Telecom and Utilities.